Monday, December 3, 2012

This market has a deja vu feeling to it. This time last year, it was faced with the prospect of Eurogeddon. This year, it's the fiscal cliff.

Regular readers know that I believe that we will likely see a Santa Claus rally (see Risk on! and Waiting for a Santa Claus rally). The most likely scenario is a relief rally based on a benign resolution of the much overhyped fiscal cliff. As I look forward into 2013, the more pressing issue becomes one of what happens after the relief rally?

An earnings cliff?
The biggest risk to US equities is what Barry Ritholz termed an "earnings cliff", which he wrote about in late October. He was seeing signs of stalling earnings growth from large cap multi-nationals (listen to this interview with him).

Peter Gibson of CIBC explained Ritholz's "earnings cliff" thesis in a more coherent manner. Gibson monitors ROEs and how their components change over time (remember the Dupont formula). He found that the profitability of companies most exposed to the global economy were deteriorating, while domestically exposed companies were doing fine [emphasis added]:

This is where the difference between the U.S. domestic economy and the global economy becomes critically important and where the issues surrounding the fiscal cliff and tax policy are critical. Simply put, our calculations of the rate of change in S+P 500 corporate profitability suggest that the U.S. economy, like all others, is slipping back into recession, but, that is not exactly correct. In fact, if we segregate the S+P 500 companies that tend to be larger multinationals with the majority of their revenues coming from international sources from the predominately domestically-focused S+P 500 companies, then the contrast is striking.

In the U.S., the “international” companies are demonstrating a significant rate of ROE decline that would clearly be consistent with a recession. This would also be consistent with the state of the global economy. The “domestic” companies, however, are recording a slight growth in profitability. This “domestic” growth rate is dramatically different than the decline in “international” company profitability but it is not yet enough to suggest that the U.S. “domestic” economy is growing at a self-sustaining rate. This “domestic” recovery is also consistent with the evidence of a recovery in U.S. housing prices. Investors must be careful, however, in their view of a U.S. housing recovery since the high level of structural unemployment tends to argue against a sustainable recovery in housing, as compared with, a recovery due to deeply depressed prices and very low interest rates. If the fiscal cliff, therefore, is not dealt with sensibly, then the tentative U.S. domestic recovery will be lost as well, and then all bets are off.

Whither Europe?
With China in a tentative recovery, the source of global slowdown is coming from Europe. Indeed, European PMIs are collapsing and eurozone economies are in recession. The macro risk in 2013 is that economic weakness in Europe has the potential to drag down China, as Europe is China's biggest export market, which create a domino effect around the world.

While I understand the concerns expressed by Ritholz and Gibson, I remain cautiously constructive on the outlook for stocks, commodities and other risky assets in early 2013. I prefer to let the markets tell the story. Consider, for example, the chart of the Euro STOXX 50 below. If the eurozone economy is such bad shape, why is this index rallying and challenging resistance at the old highs?

Why are industrial metals like copper rallying?

While I am aware of the risks of a European slowdown pulling down the rest of the world (and my views are subject to change), I don't see the "earnings cliff" to be a major headwind for equities going into 2013 at this time. However, with equities cheap on a relative basis against junk bonds and moderately expensive on an absolute basis (see my last post How cheap are stocks? (two views)), I can't say that I'm wildly bullish either. I am only expecting modest upside for stocks in a hypothetical Santa Claus/post-fiscal cliff rally environment.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. I may hold or control long or short positions in the securities or instruments mentioned.